Prioritization, Credit Risks and the Potential for Default

Does going with "prioritization" if we going through the debt ceiling remove the risk of a debt default, defined in this post as a missed payment on the interest or principal of government debt? Suzy Khimm reports on the extensive talk on the right about how the government can't debt default if it decides to prioritize interest payments by paying them first. There's a lot of pushback on this line of reasoning (see Ezra Klein, Brian Beutler).

The bigger danger is what happens when the government has to balance its budget in a single day. But it is worth shutting down this specific line of reasoning. Sorry conservatives: though it doesn't guarantee a default, going with this plan significantly increases the probability of default, which is what markets will be looking for.

With no legal authorisation for net debt issuance, the Treasury would be forced to immediately eliminate the deficit - a fiscal contraction twice as great as the recently avoided 'fiscal cliff' - by delaying payments on commitments as they fall due. It is not assured that the Treasury would or legally could prioritise debt service over its myriad of other obligations, including social security payments, tax rebates and payments to contractors and employees. Arrears on such obligations would not constitute a default event from a sovereign rating perspective but very likely prompt a downgrade even as debt obligations continued to be met.

Even if we successfully prioritize we'd be a higher risk for a default, prompting a downgrade. Trying this "prioritization" plan is not risk-free, but instead introduces substantial credit risk into government debt. I want to justify Fitch's assessment by looking at what would happen.

As a former credit risk financial engineer who's been around a default probability transition matrix in his day, I see 5 major credit risks introduced by prioritization, which means it doesn't eliminate the risk of a debt default but in fact increases it. Let's get them in a chart:

Let's go through them.

1. Will It Work? The first, and most obvious, problem is that it isn't clear that they'll be able to do this successfully after the debt ceiling is breached. It hasn't been done before. As Brad Plumer notes, Fedwire, the program that handles interest payments, is seperate from the computers that handle other payments. Maybe this means it can work better; maybe it means that it won't be able to sync cash balances. As far as I can tell, nobody knows how this will work in an environment of extreme shutdown. If there are computer glitches, if the IT crowd can't get it all working in time, there's a chance of missing a payment and defaulting.

2. Will There Be Enough Revenue? According to the BPC, February 15th has a $30 billion dollar interest payments with only $9 billion dollars coming in the door. Will we be able to make that payment? In general, we'll know the interest payments well in advance. However the revenues coming in will be uncertain, and, especially if we are making other payments, it may be difficult to match them up. Even a small mismatch could mean a default.

3. Legal and Political Blowback. The civil unrest of paying foreign creditors while Social Security, military and domestic spending goes unpaid will be massive. One can easily see discontent in the streets over such a plan. If we are worried about future payments, this kind of rage generates future credit risks, and could cause the government to switch to a non-prioritization regime.

Meanwhile, there will be extensive lawsuits, both over the lack of payments and President Obama's legal authority to prioritize payments. No matter what people are saying, the President's authority to legally do this is uncertain. Will the courts force him to pay claims in a different manner? All of this leads to huge uncertainty over the payments themselves, which amplify the chance of missing a payment.

4. Rolling Over Debt. There's $500 billion dollars worth of debt that will need to be rolled over during the first month after we go through the debt ceiling. If, for some reason, any of it can't be rolled over, and there isn't a sufficient cash buffer built up, that would be a default. This is unlikely, though how unlikely it is is depends on numbers 1-3 and the level of economic chaos going through the debt ceiling generates. Especially if we are past the debt ceiling for a substantial period of time, rolling over our debt won't be a trivial operation. Though it is unlikely, if it happens it is an automatic default.

5. Repeat Again Next Time. If Republicans are successful at pulling this off, they will do it again the next time the debt ceiling comes up. This will mean the risk of the first four factors identified are intensified.

If anyone tells you that the credit risks from number 1-4 are zero, they are lying to you. Each of these has a very small chance of causing a debt default. Added together, they have a non-negliable chance of debt default such that the financial markets, and citizens themselves, should take note.

Even if you think the chance of default in going through the debt ceiling is only about 2 percent, a 2 percent expected probability of default over the course of one year is what junk bonds have. This may be surprising for some of you, but even very small probabilities of default are big problems for firms. If there's a 0.87% chance, for instance, of default over the course of one year, that's non-investment grade debt.

The government has no possibility of default except for this debt ceiling; hence our normal high rating. However the debt ceiling is where many on the right want to extract maximum concessions, even though it is the one place where you could see a chance of default. This, regardless of what they'll tell you, has consequences.